By: Rudman Winchell Attorney Jonathan Bench
April brings flowers, showers and the Internal Revenue Service (“IRS”) to mind, and you may mull over what could have been done differently in 2012 to reduce your tax liability. If your accountant mentioned the words “imputed income,” you may have worked out a new meaning for the acronym IRS, such as your “Interest Rate is Suspect.” A lender must report to the IRS the amount of interest income it received each year (Internal Revenue Code § 7872), but individuals who loan money to friends and family do not usually consider themselves lenders in the traditional sense and do not, like most businesses, compile an income statement each year. Because a lender generally benefits from the transaction because of the interest it can charge, the IRS will come knocking on your door if it thinks your interest rate does not measure up. Specifically, if you do not charge any interest or enough interest on money you loan to others, you will be issuing a below-market loan, meaning you are lending money at a below-market interest rate. The IRS will attribute (read: impute) the interest you would have received, if you had loaned money at the going market interest rate, as your additional income. In essence, everyone else in the U.S. is doing it, and it is plain un-American not to charge interest.
The minimum amount of interest you should have charged to avoid this is called the Applicable Federal Rate or the AFR. The AFR is the lowest interest rate a promissory note can carry in order for the note holder to avoid imputed income by the IRS. As prescribed by section 1274(d) of the Internal Revenue Code, the IRS publishes the AFR monthly. Because the term of promissory notes vary in length (e.g., 1-year term, 5-year term, 30-year term, and so forth), the IRS publishes three AFRs each month, and the AFR depends upon the length of the debt obligation: short-term, mid-term and long-term. Short-term AFRs are determined from the one-month average of the market yields from marketable debt obligations, such as U.S. government t-bills (Treasury bills) with maturities of three years or less. Mid-term AFRs are calculated from obligations with maturities of more than three and up to nine years. Long-term AFRs are determined from bonds with maturities of more than nine years. The rates are further broken down by the time period over which the interest is compounded: annually, semiannually, quarterly or monthly. These rates are used to determine the unstated interest and gift tax and income tax consequences of below-market loans.
The IRS imputes the foregone interest, calculated as the AFR minus the interest rate on the note, as interest income to the lender. For example, the AFR for a debt obligation of $100,000 over five years (a mid-term note), issued in April 2013 is 1.09% if the interest is compounded annually. The lender should expect to make $992.44 in interest in the first year of the loan, and the IRS will attribute that income to you as the lender. To determine the AFR that is right for your situation, some helpful websites include the IRS’ AFR page, which lists the AFRs by month since the year 2000, The Wall Street Journal’s AFR page, which lists the AFRs for the current month, and Dan Evans’ AFR page, which aggregates the AFRs for each year as they are published each month by the IRS, making his webpage more useful at a glance than either the IRS’ or the WSJ’s.